The purpose of this study is to examine changes in corporate governance structures around the filing of Chapter 11 bankruptcy protection. Information was gathered for companies contained in the sample of the twenty largest Chapter 11 bankruptcies for the years 1995-1997. Data was collected for each company three years prior to filing, the year the company filed and three years post filing. The board of directors was classified into inside directors, gray directors and outside directors. Ownership was studied with regard to total board ownership in the company and the percentage each member held in comparison with other members. The members serving on the auditing committee and compensation committee were also recorded, as well as total committee size. Once the data was collected, the Wilcoxon Test and the matched pair test were used to detect significance. These tests both yielded a significant change for the following: a decrease in size of the audit committee, a decrease in the number of gray directors, a decrease in total board size, and an increase in the percentage of ownership per outside director. These restructuring changes support studies showing that certain characteristics of boards may prove to be more beneficial for a firm.B.S. (Bachelor of Science

Tiedt, Kristine

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Northern Illinois UniversityChanges in Corporate Governance StructuresPreceding and Following Chapter 11 BankruptcyA Thesis Submitted to theUniversity Honors ProgramIn Partial Fulfillment of theRequirements of the Baccalaureate DegreeWith University HonorsDepartment of FinanceKristi ne TiedtDeKalb, IllinoisMay 11, 20021Advisor: Robert Miller Advisor's Department: FinanceDiscipline: Finance Year: 2002Page Length: 22 Bibliography: Yes Illustrated: NoPublished: NoHonors Thesis AbstractThesis Submission FormAuthor: Kristine TiedtThesis Title: Changes in Corporate Governance Structures Precedingand Following Chapter 11 BankruptcyCopies Available: Hard Copy, DisketteAbstract:The purpose of this study is to examine changes in corporate governancestructures around the filing of Chapter 11 bankruptcy protection. Information wasgathered for companies contained in the sample of the twenty largest Chapter 11bankruptcies fqr the years 1995-1997.Data was collected for each company three years prior to filing, the yearthe company filed and three years post filing. The board of directors wasclassified into inside directors, gray directors and outside directors. Ownershipwas studied with regard to total board ownership in the company and thepercentage each member held in comparison with other members. Themembers serving on the auditing committee and compensation committee werealso recorded, as well as total committee size.Once the data was collected, the Wilcoxon Test and the matched pair testwere used to detect significance. These tests both yielded a significant changefor the following: a decrease in size of the audit committee, a decrease in thenumber of gray directors, a decrease in total board size, and an increase in thepercentage of ownership per outside director. These restructuring changessupport studies showing that certain characteristics of boards may prove to bemore beneficial for a firm.3Changes in Corporate Governance Structures Preceding and FollowingChapter 11 BankruptcyIntroductionThe role of corporate governance has become a major issue in recentyears. This is partially attributed to current events such as the collapse of Enron.The effects of corporate governance can have a serious impact on the globaleconomy. Ira M. Millstein, senior partner at Weil, Gotshal & Manges LLP, sharedhis comments in an interview with Business Week (Garten 2002), "Goodcorporate governance protects shareholders' interests and therefore leads tomore investment from the United States and elsewhere into developingcountries." The article further expanded on Millstein's quote, "From Brussels toBeijing, there is growing awareness that problems relating to auditing,transparency, and boards of directors need serious attention. It's an importantmoment. Regulators and CEO's should take advantage of it." The articlediscussed the importance of future legislation as well, "The SEC should establishnational standards relating to the qualifications and responsibilities of boards ofdirectors by refining the definition of what constitutes an independent director andspecifying the duties of the audit and compensation committees."The purpose of this study is to examine changes in board composition, theauditing committee, the compensation committee, and equity ownerships ofboard members around the filing of Chapter 11 bankruptcy protection.Information was gathered for companies contained in the sample of the twentylargest Chapter 11 bankruptcies for the years 1995, 1996 and 1997. Thebeginning sample of sixty companies was narrowed down to eleven due to the5to file for Chapter 11. There are minor exclusions to this rule including insuranceand banking institutions, stockbrokers and commodity brokers.The filing of Chapter 11 may be voluntarily or involuntarily. A voluntaryfiling initiated by the debtor begins by filing with the bankruptcy court andconstitutes the entry of an "order for relief." For an individual or soleproprietorship, no evidence of authorization to file is necessary other than thedeclaration of an affidavit that is attached to the petition. In a partnership, allgeneral partners must agree to the petition and may be filed on behalf of thepartnership by one or more of the"general partners. If all general partners do notagree to the petition, the filing is treated as involuntary. Evidence of adeclaration by the board of directors authorizing the filing of a petition is generallyfiled with the petition for a corporation, although it is not always required.Unlike a voluntary petition, an involuntary petition does not constitute anorder for relief. The debtor is given time to challenge the petition. An"involuntary gap" period takes place where the debtor continues to operate itsbusiness and may sell off property unless otherwise ordered by the court. Aninvoluntary petition may be filed against any entity that is eligible for a voluntaryChapter 11 petition, excluding a farmer, family farmer or not-for-profitcorporation. For an involuntary petition to take place, there must be at leastthree petitioning creditors when there are twelve or more holders of claimsagainst the debtor. On the other hand, there only needs to be one petitioningcreditor if there are fewer than twelve holders of claims against the debtor. Thepetitioner must have secured claims of at least $5,000, and declare that the7Certain circumstances require the appointment of a trustee. If thesecircumstances do not exist, the management of the debtor retains control, and isexpected to continue normal business activities. The current management team,termed debtor-in-possession, is left in place since they are the most familiar withbusiness activities, therefore maximizing potential for a successfulreorganization. The debtor in possession has the following rights: operate itsbusiness, receive the benefits of the automatic stay, enter into transactionsincluding the sale or lease of its property, obtain unsecured credit and incurunsecured debt, begin or prosecute actions to recover property or avoid liens onproperty, and receive the benefits of the extension of time of various periods oflimitation.If the appointment of a trustee would be in the best interests of creditors,current management may be ousted. A trustee is appointed after notice and ahearing if fraud, dishonesty, incompetence, or gross mismanagement of thebusiness is or has been displayed by current management. The only other casethat requires the appointment of a trustee is if such an appointment is in theinterests of creditors, any equity security holders, and other interests of theestate. The United States trustee selects a trustee after the court orders theappointment. There has been a more recent trend towards the appointment of atrustee due to lack of confidence by creditors in the current management.Under state law, shareholders possess the right to an annual meetingwhere the election of directors takes place. However, provisions of theBankruptcy Code dealing with management of the debtor-in-possession do not9bankruptcy process, firms will reduce the size of their board of directors in orderto increase effectiveness.Another study done by Brickley, Coles and Terry (1994), examined thepresence of outsiders on the board of directors. The results were consistent withthe idea that outside directors better serve the interests of shareholders. Thiscan be partially attributed to reputation concerns and fear of lawsuits byshareholders. Considering the bankruptcy process can cause several problemsbetween management and shareholders, one can conclude that the presence ofoutsiders on the board of directors will most likely increase prior to and followingfiling Chapter 11. However, if there is an increase in the percentage of outsiders,there must be a drop in either gray directors or insiders to compensate for thedifference. The entire make-up of the board preceding and following filing will bestudied for this reason.A recent article appearing in CFO magazine discussed the implications ofthe accounting problems facing Enron. One of the difficulties foreseen isconvincing qualified executives to accept audit committee nominations, says BobWilliamson, CFO of investment bank vFinance Inc., and a former audit committeemember and CFO of Equinox Systems Inc. For these reasons, predictionsregarding the size of the audit committee during bankruptcy proceedings show adecrease in size. Information on the compensation committee will also becollected in order to see if this prediction holds true for committees in general, orif the information is specific to the audit committee.11representatives, independent investors, or other independent directors. Thenumber of shares outstanding will be collected in order to determine ownership inthe company for each board member. Ownership is studied with regard to totalboard ownership in the company and the percentage each member held incomparison with other members to determine control of the board. The membersserving on the auditing committee and compensation committee will also berecorded, as well as total committee size.Once the data is collected, both parametric and non-parametric tests willbe used to test for significance. The Wilcoxon Test will be used as the non-parametric test. This requires the data to be ranked according to the absolutevalue of the magnitude between the data pairs. Once the ranks are calculated,each rank assumes a sign (+ or -) depending on the original magnitudedifference. By using this procedure, more weight is given to a pair showing alarge difference than a small difference. The sum of the positive and negativeranks are calculated to find T, which is equal to the absolute value of the lesservalue between T+ and T-. T is then compared to the critical value for the samplesize to see if significance exists, or if the data is merely due to chance.A matched paired test is used to test for differences between the means.The standard deviation of the differences is calculated and divided by the squareroot of the sample size. The average of the differences is then divided by thestandard deviation of the average differences to find a T value, which is.compared with the critical value to test for significance.13outsiders on the board, parametric tests showed marginal significance for anincrease in percentage. This partially supports our hypothesis based on thestudy done by Brickley, Coles and Terrry (1994) that outside directors are moreindependent monitors. In summary, the percentage of gray directors serving onthe board decreases after bankruptcy, while the percentage of outsiders on theboard of directors increases after bankruptcy. One possible explanation is that itis hard to remove insiders, considering the power they possess over the board.Often, the chairman of the board is also the chief executive officer. In fact, inNovember of 2001, of the 30 companies listed on the Dow Jones, 23 companieshad a CEO who was also serving as Chairman of the Board. However, duringthe bankruptcy process, investors prefer outside leadership since it was thecurrent management that brought the company into bankruptcy in the first place.Also, as discussed previously, outsiders serve in the interests of shareholders.Therefore, the shareholders replace gray directors with outside directors.Although the percentage of insiders on the board is relatively stable, thepercentage of ownership by insider directors decreases by almost 20%. Thepercentage of gray ownership is almost exactly equal for the years t = -3 and t =3, even though there is a decrease in the number of gray directors serving on theboard. The decline in ownership by the insiders is made up for by the 20%increase in ownership by outsiders for the six-year period. Although it may seemas if insiders are selling off part of their stake in the company, this is not the caseconsidering the 41% of ownership per inside director stays the same. Therefore,the board size must increase or decrease in size to make up for this change.15direction the company is headed. These members are not replaced until thefollowing annual meeting and may never be replaced.By studying the board of directors as a whole, the data shows that boardsize significantly decreases. The data is consistent with the Yermack (1996)study conducted on board size discussed previously. On average, the board sizedecreases from 9.36 at t = -3 to 6.73 at t = 3. Board size decreases in seven outof the eleven companies analyzed throughout the bankruptcy process. LomasFinancial, for instance, had a board size of seventeen prior to filing Chapter 11,yet the board had shrunk to five members three years following the filing. Thehypothesis that smaller boards are more effective has consistently beensupported, which explains why board size may decrease throughout thebankruptcy process. Board composition can be further broken down intoinsiders, outsiders and gray directors. Statistical tests did not yield a significantchange for the number of insiders or outsiders serving on the board. However,parametric and non-parametric tests yielded a significant decrease in the numberof gray directors. As discussed previously, this may be attributed to the disposalof gray directors by inside directors. By engaging in this process, there is moreroom for outsiders, which would send a positive signal to shareholders.ConclusionThis paper documents changes in corporate governance including boardstructure, ownership and committee structure before and after bankruptcy. Ireport statistically significant changes in the size of the audit committee, numberof gray directors serving on the board, total board size, and percentage of17ReferencesBetker, Brian L., Stephen P. Ferris & Robert M. Lawless, 1999, "Warm withSunny Skies': Disclosure Statement Forecasts," American BankruptcyLaw Journal, 809-834.Brach, Ben, "Streamlining the Bankruptcy Process," Financial Management,Volume 27.Brickley, James A., Jeffrey L. Coles & Rory L. Terry, 1993, "Outside Directorsand the Adoption of Poison Pills," Journal of Financial Economics 35,371-390.Carcello, Joseph V. & Terry L. Neal, 2000, "Audit Committee Composition andAuditor Reporting," The Accounting Review, 453-467.Cook, J. Michael, 1993, "The CEO and the Audit Committee," Chief Executive,44-47.Daily, Catherine M., 1995, "The relationship between board composition andleadership structure and bankruptcy reorganization outcomes," Journal ofManagement, 1041-1056.Daily, Catherine M. & Dan R. Dalton, 1994, "Bankruptcy and corporategovernance: The impact of board composition and structure," Academy ofManagement Journal, 1603-1617.Daum, Julie H. & Bettina M. Whyte, 2001, "Delicate state: Board selection inbankruptcy,"Directors & Boards, 54-57.Dobbs, C. Edward, 1980, Reorqanizations Under Chapter 11 of the BankruptcyCode, The Harris Company, Norcross, Georgia.Garten, Jeffrey E., 2002, "Corporate Standards; Raise the Bar Around theWorld," Business Week, 26.Gilson, Stuart C., 1999, "Bankruptcy, boards, banks, and blockholders," Journalof Financial Economics, 355-387.Goodman, Amy L., 2001, "Survey of Audit Committee Charters and AuditCommittee Reports in 2001 Proxy Statements," Insights; The Corporateand Securities Law Advisor 15, 13-18.Kroszner, Randall S. & Philip E. Strahan, 1999, "Bankers on Boards: Monitoring,Conflicts of Interest, and Lender Liability," NBER Working Paper No.W7319.19Table 1Statistical Summary of ResultsThe sample includes companies that were listed in the twenty largest Chapter 11 bankruptcies forthe years 1995, 1996 and 1997 and filed proxy statements for the time periods t = -3, t t = 0 and t= 3. Standard deviations for each category are shown in parentheses.Panel A: Board Structure Mean-3 3% Insiders 24.37 25.56(9.33) (11.47)% Gray 36.63 24.28(19.73) (18.21)% Outsiders 39.00 50.26(20.92) (24.55)# Insiders 2.18 1.73(0.87) (0.90)# Gray 3.36 1.55(2.34) (1.29)# Outsiders 3.82 3.45(3.22) (2.21)Total Board Size 9.36 6.73(3.59) (1.95)Panel B: Ownership Mean-3 3% Inside Ownership 78.83 59.31(27.92) (32.22)% Gray Ownership 15.34 15.42(28.70) (27.10)% Outside Ownership 5.82 25.27(6.87) (31.18)% Inside Ownership/Director 41.99 40.09(29.93) (25.88)% Gray Ownership/Director 3.87 7.49(5.21) (13.61)% Outside Ownership/Director 1.38 6.40(1.89) (7.84)% Shares Owned by Board 11.23 18.72(18.16) (18.09)% Shares: Officers & Directors 13.70 21.19(18.49) (19.04)Panel C: Committees Mean-3 3# Audit Committee 3.73 3.18(0.90) (0.87)# Compensation Committee 3.18 2.73(1.33) (1.42)21Median-3 325.00 22.2233.33 28.5740.00 50.002.00 1.002.00 2.002.00 3.0010.00 7.00Median-3 384.24 55.463.90 1.562.73 13.5632.03 33.140.89 0.390.91 1.924.85 16.487.32 16.44Median-3 33.00 3.003.00 3.00

Changes in Corporate Governance Structures Preceding and Following Chapter 11 Bankruptcy

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